Is There An Active Edge In U.S. Small Caps?

Attractive valuation aside, a wide gulf of performance exists within Russell 2000 Index names. In fact, 30%-35% of companies in the Russell 2000 are currently unprofitable, with a combination of shrinking has-beens and incubating might-be companies.  Pundits have claimed that the small-cap class is littered with low-quality companies, a function of companies staying private longer or the best ones snapped up by private equity. However, we see no marked deterioration in small-cap fundamentals; our view is supported by independent research from Acadian Asset Management that there is no compelling evidence of a downward trend in return on assets within the Russell 2000.

So there are plenty of great quality companies out there – the other 65-70% at least. Many are mature firms with growth engines, strong earnings, steady cash flows and dividends, while others are breakout performers in rapidly evolving industries.  The profitable ones typically have conservative balance sheets and may generate greater free cash flows than the broader small-cap market. And the earnings growth of most profitable Russell 2000 companies significantly outpace the average company in the Index.

Profitable small caps also appear not as susceptible to market gyrations: The median 5-year market beta of profitable stocks in the Russell 2000 Index is only 0.97, while the median beta of unprofitable stocks sits at 1.32.  In terms of risk, unprofitable small caps give the rest a bad name. Separating the “wheat from the chaff” is vital, but passive funds are generally restricted to Index names – essentially funding negative earners or illiquid names still in the Russell 2000 population – hoping to merely average away the losers.

Small-cap indices are far more diversified than their bigger counterparts.  At the end of May 2023, the S&P 500 consisted of 503 stocks. However, due to the presence of the Mag 7, holding the S&P 500 Index was comparable to maintaining an equally weighted portfolio of approximately 60 stocks.  In contrast, the Russell 2000 Index, with nearly 2,000 constituent stocks, displayed a less concentrated weight distribution, equivalent to an equal-weighted universe of approximately 900 stocks. In theory, this level of diversification is great… but not if you are beholden to the Index.

Much has been written about small caps underperformance vs. their large-cap counterparts for much of the past decade, yet few discuss a leading reason for this dispersion: sectoral composition.  Specifically, the Russell 2000 and other small-cap indices often disproportionately weight consumer sectors, energy, financials, and industrials, while less exposed to high-growth (and sometimes “pre-profit”) sectors like IT.  The same can’t be said for the large cap market, dominated by Nvidia, Apple, Microsoft and the like.  If the Russell 2000 Index favored IT like the Russell 1000 did, results could have been dramatically different. Passive investors have to accept these Index defined sectoral commitments —active managers do not.